Is VIX Beckoning The Bear?

The FOMC issued guidance at its Wednesday policy meeting to the effect that
interest rates would remain low into the foreseeable future. It further lowered
the pace of its monthly asset purchases by $10 billion to $35 billion per month.
The Fed also said it expects the unemployment rate to range between 6.0% and
6.1% for the rest of the year, which is slightly lower than its previous projection.

Aside from the new high in the S&P 500, the other conspicuous milestone
achieved today was the decline of the CBOE Volatility Index (VIX) to 10.60,
a new low for the year. Market volatility also made headlines by falling to
levels not seen since 2007.

Low volatility has been a double-edged sword for investors. It has undoubtedly
helped soothe the nerves that characterized the last couple of years. Investors
have been far less prone to panic at the appearance of bad news in recent months.
The latest flare-up of tensions in Iraq and the subsequent spike in oil prices
was essentially shrugged off by the stock market. That most certainly would
not have been the case six-to-12 months ago.

Yet low volatility has a negative side as well. It often lulls investors into
a false sense of complacency. The fact that the VIX is hitting its lowest levels
in over seven years during summer, with its seasonal tendency toward low participation
anyway, could prove to be a stumbling block for stocks in the near future.

Low volatility is already making life difficult for traders and fund managers
who depend on a certain amount of volatility for trading opportunities. The Wall
Street Journal recently published an article entitled, "Big Investors Lose
Even as Markets Rise." The article detailed the trading woes of some of Wall
Street's biggest investors, many of which have lost money in wrong-way bets
in global markets. This is in spite of the fact that both stocks and bonds
are in a well-established rising trend.

Famous fund manager Louis Bacon was down 5% this year through the end of May,
partly attributable to the misreading of broad economic and financial trends.
Paul Tudor Jones' hedge fund is down 4.4% year to date. Alan Howard's fund
has also posted a YTD loss, according to WSJ. Jones joked at a recent investor
conference, "I actually find myself daydreaming about winning 'Dancing With
the Stars' on some days in the office. It's gotten to be very difficult, when
you depend on price movement to make a living, and there is none."

According to the WSJ article, "An unusual period of calm has exacerbated problems
for many trading strategies dependent on volatile markets." The losses incurred
by these investors have contributed to a trading slowdown hurting the largest
investment banks. This underscores the fact that a certain amount of volatility
is vital for the hedge fund industry, and a lack of volatility - even in the
midst of a sustained bull market - can lead to diminished trading volumes and
even losing investment strategies.

Options traders are aware that periods of extended low volatility usually
set up volatility spikes down the line; that is, low volatility often precedes
stock market declines. The relationship between low volatility and market tops
isn't firmly established, however, so there's no way of predicting when a bull
market will reverse based on volatility alone. Indeed, low volatility can sometimes
persist for months or even years before eventually reversing. For instance,
the last major reversal of low volatility occurred in 2007 after remaining
near record lows for some two years.

Analysts who are predicting an imminent market crash or bear market based
on the market's low volatility factor are basing that guess on a slender thread
of historical evidence. The fact remains that there is no way of predicting
market turns in the immediate-term based on volatility alone. At best, the
most we can conclude is that today's low volatility will eventually, at some
point in the future, give way to increased volatility. When that point will
be is anyone's guess.

Right now the market's main trend remains up according to the interim trend
index as well as the NYSE internal momentum indicators. The S&P 500 remains
above its rising 15-day moving average, showing that the immediate-term uptrend
is still intact. The NYSE directional indicator (below) also remains bullish,
showing the market's short-term path of least resistance to also be up. Until
these indicators reverse we can only assume that buyers still control the market
and that bears will have to continue biding their time before making a stand.

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Clif Droke is a recognized authority on moving averages and internal
momentum. He is the editor of the Momentum Strategies Report newsletter,
published since 1997. He has also authored numerous books covering the fields
of economics and financial market analysis. His latest book is Mastering
Moving Averages. For more information visit www.clifdroke.com